Cannabis Accounting 101: Understanding Change of Biological Assets

Today we present a brief guide to one of the trickiest aspects of assessing a Canadian cannabis company

John Brooker | June 17, 2019 | SmallCapPower: When researching cannabis companies, you may notice that it is standard for companies to report higher gross profit than revenue. For example, the last reported quarters for Cronos, HEXO, and CannTrust were revenue of $6.5M, $13M, and $16.9M, respectively. However, the gross profits reported were $13.3M, $21.8M, and $33.7M, respectively.

Cronos Group

HEXO Corporation

CannTrust Holdings

The reason why these gross margins are significantly higher is because when these companies report, COGS are further adjusted by the value of “change of biological assets.” This change is often accounted as a positive adjustment to the COGS, as it considers all the cannabis plants that are in inventory by quarter-end. Importantly, there appears to be no standard for this biological asset figure, as different cannabis companies have different ways of calculating this value. For example, Canopy Growth Corp accounts by the age of the plant – if a plant is closer to harvest – is it worth more. Others, use methods such as historical averaged wholesale price per gram.

Although these inflated margins may seem misleading, this method of accounting was adopted by other agricultural industries. In fact, under International Financial Reporting Standards (IFRS), marijuana producers must use an accounting practice unique to the agricultural sector that pre-books income for crops as they grow.

The difference in cannabis is that the change of biological assets is highly influenced by the operating cultivators. By cutting plants and creating new clones, a company can drive higher gross margins in an income statement and higher inventory on a balance sheet. As a result, cannabis companies can report positive EPS but have negative CFPS.

In our opinion, in general, it is important for an investor to be aware of these inflated gross margins, as it does not effectively evaluate most revenue-generating cannabis companies. We highly recommend diving deeper into financial analysis to find a closer reality to the true health of a cannabis company. As such, since there is no standardized method of reporting biological assets, in our opinion, we strongly recommend focusing on cash flow from operations, or free cash flow, rather than gross margin and book value.

To read our full disclosure, please click on the button below: